Germany’s Bundesbank (the country’s central bank—equivalent of the Federal Reserve) is one of the most respected financial institutions in the world. The Bundesbank is renowned for its success and its resolve in fighting inflation. Much of this success stems from its true independence, and this turned the German Deutschmark into one of the world’s strongest currencies. It was with some reluctance for many Germans that the Bundesbank ceded monetary authority to the European Central Bank in conjunction with the creation of the Euro. Bundesbank President Jens Weidmann has been one of the foremost voices in European Central Banking, and he continues to champion sound money and central bank independence.
It was with great anticipation that I went to the Deutsche Bundesbank office in Berlin. We were meeting only a few hours after the Greek referendum, and Germany is clearly viewed as the leading voice speaking for “Europe.” I met with Dr. Albrecht Sommer, the Head of the President’s Staff, and with Matthias Schrape from the Regional President’s office. Our meeting provided valuable insights on both the future of Germany and on the concept of Europe.
I expressed some surprise that the Greek people voted “No.” Dr. Sommer stated that this was actually his expected outcome. Here are some of my observations and thoughts from our discussion:
This crisis continues to forge new ground when it comes to the Eurozone—no one really knows what will happen next. The situation is clearly more manageable than it was a few years ago, and it seems that the right instruments are in place to deal with the problem.
Greece has clearly violated the rules, but country-level economic rules always have exceptions. There is no rule for a country without an escape clause! The immediate financial impact from Greece will be small. There could be some widening of spreads for some of the other Southern European countries, but it is unlikely to be large. The real problem comes in the next recession. If Greece leaves or gets a different deal, how does the Eurozone deal with a country like Italy and its large public debt during the next crisis?
What European leaders fear most is that Greece leaves and it actually experiences a strong recovery. This example would be troubling for the rest of Europe. Economically, Greece does not matter, but it is the example that the Euro is not irrevocable that becomes problematic. Europe still faces a significant obstacle in its high levels of private debt. This acts a drag on growth, and it feeds into higher unemployment and political instability (see the right-wing movements in Spain and France).
Greece is less significant than a few years ago because Greek debt is predominately in public hands. While Greece’s political leaders may think that their hand is strengthened after the “No” vote, each of the Eurozone countries have mandates from their citizens as well. Importantly, the German Parliament will have to approve any rescue package. This will take time and will be difficult.
Greece’s problems will not be solved by leaving the Euro. In essence, Greece is really a failed state. It experiences weak tax administration, no centralized documentation of business, and is rife with corruption. There is very little industry in Greece. These issues are not solved by devaluation. Greece would be best off to stay in the Euro and try to get European technical assistance to implement structural changes. Unfortunately, Greek politicians and the populace are not interested in these solutions.
From Germany’s perspective, Greece is not the biggest concern. There real concern is how to speed up growth in France and Italy (these are large, critical export markets for Germany). When we talked about the impact of Quantitative Easing (QE), the discussion highlighted the fact that much of the impact of QE occurred before it actually started. The discussion and announcement of QE pushed down yields on government bonds, collapsed bond spreads, and drove the Euro lower. The move was too exaggerated, and the correction from the lows is appropriate.
QE has had less impact on corporate investment. There is little sign of recovery in investment by companies or the public sector. There remains a hesitancy to invest. While a depreciating Euro has helped Germany, the country could live with a stronger Euro. Many of Germany’s exports do not compete on price—they are often high value add, high quality, and less price sensitive. A weaker Euro has been more important for France and Italy.
The dominant transmission channel for European QE has been the Euro. The exchange rate will remain the dominant channel. The wealth effect from European QE is less than in the U.S., because stock markets in Europe are less relevant. Europe is a bank-based financial system. This highlights some of the long-term projects needed by Europe—harmonization of regulations around capital markets. QE doesn’t work the same in Europe, because its financial markets are so segmented.
The discussion again highlighted some of the divergent interests that exist in Europe. This explains why it is so difficult to find short-term solutions. In their view, future success and integration will require more political and fiscal union—Europe needs more power in centralized institutions. However, public opinion is going in the exact opposite direction. It will be a step-by-step process—banking union and capital markets harmonization are key steps.
Fiscal union goes right at the heart of what is needed in Europe, but public opinion is in anti-European mode in many countries. Realistically, the status quo is probably the most that can be hoped for at the moment.
This continues a theme that I heard in Paris and in London—it’s not the financial contagion to worry about from Greece, it is the potential for political contagion in the future.
Special thanks to Brennan Staheli, Joseph Hirschi, and the Lunt Capital team for their contributions to this report.